Fiscal cliffhanger

U.S. House Majority Leader Eric Cantor (R-VA) (L) looks on as House Speaker John Boehner (R-OH) speaks to the media on the "fiscal cliff" on Capitol Hill in Washington, December 21, 2012.

House Republicans left town in disarray on the evening of Thursday, December 21, after rejecting Speaker John Boehner’s “Plan B.” That bill would have avoided the tax cliff in January even as it allowed tax rates to rise for millionaires. (A separate bill, which did pass the House, would turn off the “sequester” as it applies to the defense budget.) If Plan B had passed, House Republicans could have told their constituents that they had approved a bill to prevent a massive 2013 tax hike on most taxpayers even as they acceded to the president’s demand to raise taxes on the rich. With Plan B in hand, Boehner would have been in a much more favorable position to negotiate with Senate majority leader Harry Reid over a possible final compromise.

Alas, it was not to be, for reasons that remain hard to fathom. It is certainly understandable that House Republicans want to avoid voting to raise taxes. But they must know that they are about to get a whopping, and probably irreversible, tax increase forced on their constituents in part because of their unwillingness to demonstrate any tactical agility in this difficult struggle. After Thursday night, the tax bill that will ultimately get handed off to American households has almost certainly gone up rather than down.

Still, one should not assume that last week’s debacle is the end of the Republican participation in this saga. Legislation cannot make it through the Senate or the House without some level of Republican support. So the question is, What should Republicans want out of this process at this point?

For starters, they should still prefer a good deal, because going over the cliff could very well reset the terms of the debate in ways that are more favorable to Democrats. Most worrisome is the possibility that a few weeks, or perhaps a couple of months, into 2013, the pre-Bush tax schedule and revenue baseline will become the new normal in American politics. This could be the case if the anemic economic recovery now under way does not worsen in any visible way as a result of going over the cliff. If no new recession is in the offing and unemployment does not rise, pressure would ease on the president and Senate Democrats, who would certainly continue to profess an interest in reinstating the middle-class tax cuts even as they pocketed the entire $4 trillion tax hike. The end result would be the most unbalanced of all budget plans: a massive revenue increase coupled with zero spending cuts and no entitlement reform.

But this does not mean Republicans should take just any deal to avoid going over the cliff. They have some leverage in this fight (although less than they did before Thursday night). The president is under great pressure to find a way out, too. It remains possible that the tax hikes and spending cuts scheduled to begin in January will be non-events for the American economy. But most experts think otherwise, including the Congressional Budget Office and Fed chairman Ben Bernanke. The consensus is that $600 billion in fiscal consolidation in a one-year period will be enough to push the economy back into a recession — a mild one, yes, but a recession nonetheless. Unemployment would probably rise above 9 percent again. Five years into the Obama administration, this would represent a large setback for the president. He would certainly try to shift the blame to Republicans, and he might even have some success in doing so. But a recession that began on his watch, not his predecessor’s, would inevitably color — and harm — his entire second term. When Republicans reenter negotiations with the president or with Senator Reid, as they inevitably will, they need to keep this in mind.

Even after the failure of Boehner’s plan, two possible scenarios for avoiding the fiscal cliff before year’s end still remain: the small “kick the can” option and the mini–“grand bargain” plan. Republicans need to be ready for either scenario.

Under “kick the can,” there’s no ten-year agreement on spending, or even on a process to produce spending restraint in 2013. It’s just a way to postpone the cliff, probably for a year. At this point, the most likely scenario is that some version of Reid’s earlier tax bill will be resurrected and passed again in the Senate. Under the earlier version, the top rate would be allowed to rise from 35 percent to 39.6 for all households with incomes above $200,000 ($250,000 for couples), on a permanent basis. At the same time, the rest of the Bush-era rates would be extended for one year for the “non-rich,” and the alternative minimum tax would get patched for 2012 and 2013.

If this becomes the vehicle for the next stage of negotiations, it’s clear what Republicans should seek: a temporary, rather than a permanent, rise in the top rate. They could argue, reasonably, that because there is no ten-year spending plan, there shouldn’t be a permanent tax hike either. Indeed, the whole point of the kick-the-can option is to buy time for more stable agreements to be hashed out over tax and entitlement policies. If a permanent tax hike is put in place, there would be no incentives for a broader deal to be reached.

The other possible scenario is the reemergence of a “grand bargain”–type plan, or at least a modest version of it. That was what Speaker Boehner and President Obama were discussing a week ago when optimism was running high. The broad outlines of that deal were relatively clear: Republicans agree to raise the revenue baseline by $800 billion (Boehner’s offer) to $1.2 trillion (the president’s offer), and in return the Democrats agree to secure that revenue through a tax-reform plan (not just tax-rate increases) and to produce entitlement reforms totaling $600–$800 billion. In addition, defense spending would be cut again, as well as non-defense appropriated accounts, even as the sequester cuts were turned off.

In theory at least, this kind of deal should be far more appealing than going over the cliff, because it would mean a real possibility for entitlement reform, and because the revenue hike, which is inevitable now that the president has been re-elected, would be achieved with a better law instead of damaging rate hikes. For Republicans, it’s hard to see a better way forward in 2013 than that.

But Republicans should entertain this kind of agreement only if the enforcement mechanisms are designed properly. More specifically, if in 2013 a tax reform plan does not emerge, then whatever rate hike on the rich was imposed to avoid the fiscal cliff should be turned off. In other words, no tax reform means no revenue increase.

Similarly, it’s imperative that Republicans not enter into a budget agreement without an ironclad assurance that it will result in real entitlement reform, which does not mean deeper and more irrational cuts in Medicare’s regulated payment systems for hospitals, nursing homes, physicians, and others. Real entitlement reform means bringing better consumer incentives into Medicare and giving states meaningful authority to run Medicaid on a predictable and more affordable budget. This is not an agenda Democrats will ever be inclined to support, but it’s the only reason Republicans should ever be willing to give on taxes. If there’s no entitlement reform, there’s shouldn’t be a budget deal either.

To ensure that is the case, the enforcement mechanism for entitlements must be drawn up the right way. The easiest way to figure out what that means is to consider the wrong way to do it. At least one press story on the Boehner-Obama talks of a week ago indicated that if there was no bill on entitlements in 2013, the draft agreement would have enforced cuts in entitlements in a manner entirely acceptable to the administration. If that was indeed what was planned, it would have been a terrible deal for Republicans. If the Obama administration can live with the automatic cuts in Medicare that are intended to force agreement on alternative legislation, the administration will never agree to more fundamental reforms of the program (such as described in this piece). It’s also a clear indication that the automatic cuts would be designed to look like the provider cuts that were enacted in Obamacare and that do nothing to change the basic spending dynamics of the program. Republicans must never agree to such a deal.

The right kind of entitlement enforcement structure is one that is equally unacceptable to both sides, thereby putting pressure on both to reach a legislative agreement. It’s easy to imagine what this would mean: in provider payments, deep cuts of a size that could not be absorbed easily (such as the 30 percent physician-fee cut scheduled for January 1); and large, automatic increases (such as increases in deductibles) in what the beneficiaries must pay for services. If such provisions were scheduled to go into effect in 2014 absent real entitlement reform in 2013, then Democrats might actually move toward an agreement.

Republicans are prone to self-inflicted wounds, and last Thursday was surely that. But this story is far from over. The GOP still has time to pull itself together and fight for a decent outcome in this struggle. Is it possible that a budget plan will emerge that will excite Republicans? No. But if they negotiate smartly, they can still make it clear to the president that he will never get the permanent tax increase he seeks unless he agrees to the fundamental tax and entitlement reforms that the country desperately needs.— James C. Capretta is a fellow at the Ethics and Public Policy Center and a visiting fellow at the American Enterprise Institute.